Best Practice May 2017

Commercial Property: Rent vs. Buy

The cost of physical space for a business typically accounts for a significant percentage of its overall operating costs. In parallel with home ownership, there are advantages and disadvantages to owning your commercial property vs. renting it.

We at Strictly Business know that business owners are pulled in a thousand directions and might not have time to stop and consider which option is right for them. This month’s Best Practices topic taps the knowledge of the Martindale Keysor & Company, LLC firm to provide some food for thought on the afford- ability of commercial property options and considerations. Armed with some building blocks and a good overview, we hope you’ll be inspired to take action.

When it comes to making substantial changes in the structure of a business, the presence of a solid foundation is an important prerequisite. Your accountant is the best person to advise you whether your business is in the position to make a bold move when it comes to property expenses. Taking time to conduct an informal practical survey of your current conditions can help you know when the time is right to call in the professionals. Do your homework and make an honest assessment of your strength in the following areas:

The bottom line: Is there growth in sales year over year? Consider the profitability of the business both historically and make a well educated forecast into the future. If you’re entertaining an increase in the cost of space for your business, this should align with the profits you are currently making. Any change in expenses will impact profits, so a healthy margin is the safest bet.

Cold, hard cash: Does the business have cash reserves? If the answer is no, it will be next to impossible to make the initial deposit required by most property sellers to ensure the commitment of a potential buyer. In addition to the initial deposit, the bank funding your loan will want a significant percentage of the purchase price up front as a down payment. Winning the lottery or generous and wealthy relatives are additional options, though harder to come by.

Room to grow: Analyze and forecast your expected five and ten year needs regarding the commercial space required to realize the goals you have for your business. This is true whether your goals are to maintain, downsize, or grow your business. If you have not done your homework, or even if you have and things change drastically in an unpredicted way, you could be stuck owning or renting a property that is too big or too small to meet your needs. Alternatively, a business could plan on purchasing property that is larger than what is needed now and earn rental income on the extra space while continuing to grow.

Location: Location is particularly important for companies that rely on traffic flow, but always a consideration for businesses. How is your current location helping or hurting your customers, suppliers, and employees? Business and economic development are moving targets, so periodic assessment of the local landscape is the best way to stay on top of emergent opportunities to make your physical location work better for your business. If location is a critical factor, renting may be the only affordable option to maintain the foot traffic needed.

Long-term investments: The growth in the value of property over time makes ownership an attractive investment. “Take a hard look at your overall net worth and what it is comprised of,” commented Rick Martindale, CPA at Martindale Keysor & Company, who counseled that maintaining diversity in the investment portfolio of a business is always a good idea. “If the market for real estate should go down, you don’t want to be fully invested in just that sector,” he said. The eventual sale of commercial property could also serve as an important financial piece in the retirement planning of the business owner.

Property management: Do you have the time and skill to manage the logistics of property ownership in addition to your current responsibilities? When you rent, the headaches of maintenance, repairs, and upkeep are very often someone else’s problem. Avoiding those details leaves you more time to do the work of running your business. On the flip side, if you benefit from having control over making adaptations to the physical space you occupy, property ownership offers considerably more flexibility.

Decision Time

Once you have done your research and uncovered your strengths and weaknesses regarding the current state of affairs in your business, you will have a clearer picture of whether a change is right for you. To take the next step forward, a deep dive into financial and tax considerations is necessary. A solid analysis comparing current costs of renting property to the costs associated with buying is the right place to start. According to Martindale, it is important to compare apples to apples when crunching the numbers. It is easy to forget about expenses that property owners typically factor into a lease such as property taxes, snow removal, maintenance, and insurance. “You need to be able to afford the monthly payment not just now but into the future,” he advised. “As a property owner, you will be responsible for all repairs and maintenance going forward, so build that into your budget and projections for affordability.”

Deciding to rent or buy is an important hurdle, but that is only the beginning. The majority of property purchases require the involvement of a bank to finance a commercial loan. Martindale advised potential buyers that qualifying for financing is a lengthy process. “The asset must be appraised high enough to make the deal work, you must have sufficient down payment and you must demonstrate the ability to meet the monthly payment through a good financial his- tory,” he explained. Though loans often start with a traditional fixed interest rate, commercial loans are often scheduled to be reviewed and adjusted periodically. This means that like rent, interest rates also carry some risk of rising over time as the lending markets change.

Financing is not only time consuming, it is costly. From various lending fees to closing costs to a hefty down payment, the available cash balance of a business needs to be ready to take a hit even before the starting line of a purchase. A business owner should carefully evaluate the overall financial picture of the business before letting go of a sizable portion of the liquid cash toward the financing. If making a purchase is too constricting on the financial ability of your business to grow and adapt to changing market demands, this might not be the right time to invest.

While it may seem like mortgagees are at the mercy of lenders, Martindale suggested that there is potential wiggle room for those who are savvy enough to seek it out. “Keep in mind all bank commercial mortgage ‘deals’ can be somewhat negotiable,” he advised, “Having several banks look at the loan can provide friendly competition that can benefit you.” Looking at an even more creative solution, Martindale suggested that the seller might have a vested interest in coming the table to move things along. “Sometimes the seller is motivated enough to provide part or full financing, or wants to act as the bank and ‘hold the paper,’” he explained. This financial arrangement can save the buyer time, and money. Perhaps most significantly, it can reduce or even eliminate the expense of a down payment typically required with traditional financing.

Finally, there are tax advantages to property ownership that impact the financial picture. The interest paid on a loan, property taxes, and all building-related expenses are some of the deductions that can significantly offset tax liability for a business. Depreciation of the building can also offer tax relief, though Martindale advised caution. “From a tax standpoint, owning property is not as advantageous as it once was because the IRS depreciation rules do require a long depreciation life of nearly 40 years on nonresidential property.”

Running a business can feel like a never-ending conveyor belt of calculated risks. Property purchase is one of the more significant—but in the end, only one of many—decisions where risk taking can lead to either great reward or crisis. While the ultimate decision of rent- ing or buying space rests with the business owner, it pays to conduct a thorough analysis and involve as many professionals as possible in the process. In addition to your accountant, it is helpful to consult with a realtor who specializes in commercial real estate, a lawyer with commercial property transfer experience, and a trusted mort- gage advisor.